PRIMER: Sonia (the Sterling overnight index average) – part 1

Author: Amélie Labbé | Published: 29 Oct 2018

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What is Sonia?

Introduced in March 1997, Sonia stands for Sterling
overnight index average. It has historically been used as a
benchmark for overnight unsecured transactions denominated in
GBP.

The Bank of England (BoE) became Sonia’s
administrator in April 2016, and as of April 2018, has also
taken over the Wholesale Markets Brokers'
Association’s (WMBA, now the European Venues and
Intermediaries Association, or EVIA) calculation and
publication duties.

The rate is in the process of being reformed with a view to
it becoming the benchmark more widely used in the debt,
structured finance and loan markets as the London interbank
offered rate (Libor) is being phased out. Libor has been the
dominant rate in the market since its introduction in the 1980s
but recent controversy surrounding its manipulation by a number
of banks led to the Financial Conduct Authority (FCA)
announcing its discontinuation it by the end of 2021.

The overarching framework of reference is the Benchmark
Regulation, which entered into force in January this year
and sets out common rules all rates have to abide by to
minimise conflicts of interest in benchmark-setting
processes.

How is it calculated?

Sonia is a measure of the rate at which interest is paid on
eligible sterling denominated deposit transactions.
It’s an overnight rate, so by definition it has a
backward-looking application. Unlike Libor, where the interest
payments are known at the start of the interest period, the
interest amount in respect of Sonia-linked floating rate notes
(FRNs) isn’t known until close to the end of the
relevant interest period. When used as a reference rate for
FRNs, it can be calculated either on a compounded basis or by
taking a weighted average rate over a particular period, and
adding a margin to it.

Recent Sonia-linked floating rate note issuances have used
the compounded basis and also use a so-called five-day
observation lag period, meaning the end of the interest
observation period lags the interest payment date by five days
to provide cashflow certainty.

"This is different to other instruments, such as FRNs linked
to the secured overnight financing rate [SOFR] used in the US,
under which a weighted average rate is used, and the same rate
is applied for the final four days of the interest period,"
said Katie Kelly, senior director, market practice and
regulatory policy at the International Capital Market
Association (ICMA).

Unlike Libor, Sonia has no term structure meaning it
doesn’t have relevant yield curves for different
maturities (one-week, three months or even 10-year transactions
for example). Libor is also quoted in five currencies including
the US dollar and the euro.

Sonia is referred to as a risk-free rate (RFR) because its
calculation doesn’t include the bank credit risk
or the liquidity premium inherent in Libor.

"We are in a situation post-Libor scandal, where the global
regulatory community, led by the Fed, the BoE and the Commodity
Futures Trading Commission, is taking a strong position that
says: anything that is transaction-linked is better than
something that involves a level of expert judgement," says one
market participant on the advisory side. "I would argue that
there is a role for well-controlled expert judgement or a range
of reasons."

Because it’s based on actual transactions,
Sonia can be a more volatile rate than Libor, and typically
sits a few basis points above or below it at any given time.
Similar concerns have been voiced against Sofr, as its
calculation is based on transactions in the overnight
repurchase agreement market which can be subject to big
fluctuations.

If Sonia is to follow in Libor’s steps and
become more widely used in the market, some adjustment is
needed. The BoE’s Working Group on Sterling
Risk-Free Reference Rates, established in 2015 to explore RFR
alternatives to Libor,
consulted until October 26 on how to ensure a broad
transition to Sonia. Many other jurisdictions are actually also
considering or consulting on moving away from interbank rates
to an overnight RFR.

But according to the advisor, "even if you build a term
structure into Sonia, and it becomes a proxy for Libor, there
still will be a delta between Sonia and Libor products".

How widely is Sonia used?

It’s been used as the reference rates for
GBP-denominated transactions for nearly 20 years. But the BoE
has previously stated that while there is awareness of RFRs
such as Sonia, there is still huge scope for the market to
grow. The Sonia market is estimated to be worth anything
between £100 billion ($129 billion approximately) or
£150 billion based on the volume of GBP denominated
overnight transactions.

This compares to the $350 trillion+ Libor market though the
value and volume of GBP contracts using Libor as their
benchmark remain uncertain.

"There isn’t currently a lot of liquidity in
Sonia contracts but there is no reason decent liquidity
couldn’t build up over time," said David Clark,
chairman of EVIA and member of
the former BoE’s Sonia advisory
committee. "But this can only happen if work is done to
improve Sonia liquidity in various tenors."

Nine debt transactions have used Sonia as the reference rate
since the beginning of the year, including issuances from RBC,
Lloyds, Santander, EuroClear, EBRD and the African Development
Bank. The European Investment Bank carried out a small test
case issuance in March 2018, following which it sold a £1
billion bond in June. It initially carried out the first ever
recorded Sonia-linked issuance, a £300 million issue, in
March 2010. There have not yet been any loans issued using the
new benchmark.

"The core point here is shifting to new Sonia-based
products, and managing the business conduct and risk around
these," said Oliver Wyman partner Serge Gwynne. "But for a bank
to be able to offer these, they need to understand risks,
pricing approaches and timelines."

Is Sonia a replacement for or an alternative to
Libor?

Both BoE governor Mark Carney, and Andrew Bailey, the chief
executive of the FCA have said that Sonia doesn’t
replace Libor but is a GBP alternative to the 30-year old rate.
The two rates have historically been built and functioned
differently so replacing one with the other
wouldn’t necessarily be the best way forward.

"Solving the Sonia issue is different from solving the Libor
problem," said Clark. "Ultimately, what the market wants and
needs is a Sonia curve for it to become a viable and more
widely-used rate, but this is not certain to happen before
the end of 2021."

Preparations are ongoing to transition from Libor to an RFR
though there is no concrete plan of action, which some in the
industry are growing increasingly weary of.

In the eurozone, the European Central Bank (ECB) asked for a
stay of execution to migrate to new benchmarks, giving banks
the time to prepare for an organised transition and
highlighting a degree of uncertainty – the EU
Commission refused this in October 2018. "The European
Commission will not grant an extension. It’s as
simple as that," said Tilman Lueder, the head of its securities
markets unit.

The ECB’s working group on euro RFRs has chosen
the unsecured overnight Ester rate (euro short-term rate),
which will be published by October 2019.

In the UK, the BoE’s Prudential Regulation
Authority and the FCA sent a letter in September 2018 to the
chief executives of the UK’s largest banks and
insurers asking them for feedback on the firms’
'preparations for transition from Libor to risk-free
rates…and ensure they are taking appropriate action now
so that your firm can transition to alternative rates ahead of
end-2021’.

What is Sonia+?

Work is currently ongoing to turn Sonia into a term rate,
and make it forward-looking like Libor – the so-called
Sonia+ rate. How this can be achieved will be the subject of
part 2 of this primer.

While derivatives such as futures or overnight indexed swaps
may transition more or less easily to Sonia – swaps
can be written on a more bespoke basis than other products
– the loan and debt markets rely on forward-looking
term structures typical of Libor, making a switch less
straightforward.

"Concerns about not knowing the interest amount in advance
are helped by the fact that Sonia tracks bank base rate quite
closely," said Kelly. "But there may be other issues, such as
infrastructure and systems’ capabilities."

Also, one key question remains: is a term rate needed for
all products?

"For some products, it’s not necessary: for
swaps, you can use overnight rates," said Gwynne. "But for
other parts of the market, in the corporate lending market,
there would be real value for the end user to have longer-term
visibility."

See also

Click here
for IFLR’s Primer series. Part 2 of this primer
will cover how to build the Sonia+ rate